Mergers and acquisitions are a complex business requiring in-depth due diligence into the financials and operations of the seller’s company. Obtaining an accurate valuation is critical, and this is where most entrepreneurs tend to overvalue their businesses.
Although just 154 domestic M&A deals occurred in the UK in Q1 2023, there’s still some optimism regarding the market in the future. If you plan on jumping in, here’s what you need to know about the art of M&A business valuation.
What is reviewed in a merger and acquisition valuation?
The number one mistake in business valuations is using an overly simplistic valuation method. This is because most people’s only valuation experience is purchasing shares as an investor.
Take the market capitalisation method as an example. This is the simplest business valuation method you can use and is calculated by multiplying the total number of shares outstanding by the share price.
For example, today, Microsoft trades at $329.91 USD. Its total number of shares outstanding is 7.441 billion. If we multiply these two figures, we get a valuation of $2,454,860,310,000. In layman’s terms, this would value Microsoft at nearly $2.5 trillion.
This calculation, however, doesn’t account for its brand value, its operations or the intricacies of a specific deal. This is why M&A valuations are much more complicated.
So, what are some of the factors appraisers look at?
Company’s Lifecycle – Where is the company in its journey? A 100-year-old company is far more valuable than one made last week.
History and Reputation – These qualitative data points go beyond the numbers to establish the true worth of a company. In 2021-22, the average UK company age was just 8.6 years. Your history and reputation will be compared to averages like these.
Growth – Is the company growing or declining?
Competition – How many competitors are in the company’s primary niche?
Prospects – Does the company have a positive or negative outlook?
Many appraisers will also consider the cost of building an equivalent business from scratch. If anyone could start a company and replicate their results within a year, this would significantly lower the value of a brand.
On the other hand, if replicating the company would be highly labour or cost-intensive, this makes a brand more valuable because it gives the seller leverage.
The definition of a genuine M&A seller’s market would be a company that cannot easily be replicated with outstanding prospects.
The merger and acquisition valuation models
Appraisers can take advantage of several valuation models to accurately assess a company. Larger organisations may even enlist multiple independent appraisers using similar or different valuation models to get as close to an accurate figure as possible.
Countless models exist, which can be split into the following categories:
Market-Based Methods – These methods use the price of comparable companies and transactions to evaluate a company. Popular methods include the transaction and trading multiples methods.
Income–Based Methods – These models rely on future cash flows or target company earnings to estimate value. Some examples may include the discounted cash flow or leveraged buyout method.
For example, when using a revenue-based valuation, you multiply annual/projected revenue by a specific multiple, depending on the industry. This can mean giving a software agency a multiple of five but a retail store a multiple of one.
Asset–Based Methods – Any method falling into this category relies on the target company’s book value or net asset values to assess its value. The net asset value method is one such example of an asset-based method.
Every method has its pros and cons. Likewise, different models all have best-case scenarios. It would be impossible to discuss every method here, so we’ve detailed a basic overview of three standard models below.
The Cost Model
The cost model is the most straightforward option for valuing a business. It relies entirely on estimating what it would cost to replicate that business from square one.
This model is most often used when a business is tangible in nature. In other words, they’re physical and sell physical goods. For example, if you were valuing the eCommerce arm of Amazon, you could create a valuation by summing the total assets.
However, the flaw in the cost approach is that it doesn’t effectively evaluate the intangibles. For example, it struggles to manage valuations when intellectual property and brand value are added to the mix.
The Market Model
Taking a market-based approach to valuation looks at the M&A market like property. Appraisers will dig into the data to find other similar businesses that sold within the last few years.
A market-based approach is highly effective when a deal occurs within the same niche or geographic market. This is because if a tailoring company in Manchester sold for X amount six months ago, a tailoring company in Manchester now will undoubtedly sell for a similar amount today.
Businesses typically use it in more traditional industries, such as retail or financial services. Lone entrepreneurs and startups in hybrid niches may lack direct competitors, so the numbers just aren’t available.
The Discounted Cash Flow Model
If you’re using the discounted cash flow model, this valuation will compare the potential future value of the business with present-day cash flows.
What does this mean in practice?
An appraiser will take a five-year or ten-year financial projection and work backwards from this future valuation to determine its worth today. This estimate is then used as the established company valuation figure.
Which valuation method is good for a merger and acquisition valuation?
All valuation methods have their purposes, but it takes an excellent appraiser to know which ones to use in which scenario.
The key is your decision must be based on provable facts. Valuations mean nothing unless they can stand up to proper scrutiny.
So, which factors will influence which valuation model is suitable? A professional appraiser will ask questions like these:
- How large is the company?
- What does the company do?
- How long has it been in business?
- Does it specialise in physical or virtual assets?
- Do intangible assets like IP need to be accounted for?
Similarly, it’s essential to consider the differences between valuing a large business and a small one.
For example, Amazon acquired online shoe retailer Zappos in 2009 in a deal worth $1.2 billion. During this due diligence process, Amazon would have had to factor in small business-specific factors like:
- Unclear ownership of assets.
- Sole trader reliance.
- Obtaining credible records.
Remember, small businesses don’t need to adhere to the same strict recording and reporting procedures of a large multinational, especially if it’s publicly traded. If you want to acquire a small business, you must hire a small business appraiser.
Which factors contribute to a valuation in a merger and acquisition?
Appraisers begin by selecting the most relevant method for your deal. With that established, they will then look at several factors when coming up with an accurate valuation.
These factors include but are not limited to:
- Assets – The material worth of a company’s assets minus its outstanding liabilities.
- EBITDA – EBITDA stands for earnings before interest, tax, depreciation & amortisation and is used to compare a seller’s company with other market prospects.
- Revenue Multiple – As mentioned above, some methods use a revenue multiple based on the type of business being acquired. By valuing a business in a way that’s proportionate to its revenue, you can figure out whether you’re getting a good deal.
- Real Option Analysis – Real options are what are known as asset-based choices. In essence, physical assets without accounting for the intangibles, like IP.
- P/E Ratio – The price-to-earnings ratio takes the business’s current share price and divides it by its after-tax profits for the purposes of comparison.
- Dividend Yield – Like the discounted cash flow model, dividend yield gauges the projected value of future dividends to prove value.
- Entry Cost – The cost to set up an equivalent business from scratch. If this is low, starting an identical opposition may make more sense than to embark upon a costly, time-consuming M&A deal.
- Precedent Analysis – This is comparable to the cost valuation method and effectively means looking at the prices of similar deals.
Note that these are merely the starting point for an appraiser. Professional valuations may bring in additional factors, or some of the above factors may have no relevance to a particular business at all.
As you can see, M&A deals are extremely complex, and the valuation portion alone can make your head spin. It underlines the importance of assembling a team that you can rely on.